Should Brokers Depend on Only One Liquidity Provider?

Sergey Shirko has been studying the forex market for about ten years, and has been working in the FX industry since 2009. He has worked at a number of companies, including TeleTrade and Soft-FX. He has been the Chief Dealer of FXOpen since December 2012.

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In this article, Jonathan Brewer describes the advantages of a Prime of Prime solution as the sole liquidity provider. I am not a supporter of using this business model, as I think that only in conditions of healthy competition can we find optimal solutions both in business and in life. I think that a business model with one liquidity provider is suitable only for a limited group of Forex brokers. I’ll explain my position below…
First of all, I would like to distinguish two main groups of retail brokers:

1. Brokers who largely operate as market makers (MM), i.e. act as a counterparty for client transactions.

2. Brokers who provide access to interbank liquidity, that is, act as an intermediary for client positions.

Of course, nowadays the line between the two is blurred. Despite the fact that a lot of retail forex brokers have in their product line both MM and ECN/STP accounts, they still continue to adhere to either the first or the second model of doing business.

Then I propose to define the goals or tasks that force both groups to seek a liquidity provider (LP).

For the first group, it is primarily the need to hedge some portion of the client’s positions and then the possibility of expanding the product line through ECN/STP accounts. For the second group it is getting a reliable supplier with consistently tight spreads, executable prices and low commissions.

the connection costs and maintenance fees of multiple providers in your system are a small price to pay for avoiding being bound hand and foot to a single LP

It is clear that the objectives of these groups differ from each other. The needs of the first group can be satisfied by almost any supplier, those of the second group cannot. We can conclude from this that the second group will be more sensitive to changes in the conditions of the liquidity provider.

Of course there are many ‘signs of compliance’ when choosing a liquidity provider, but for the purposes of this article we are only interested in tasks which forex brokers try to solve when selecting an LР.

Thus we will not list here all the criteria that liquidity providers are required to meet.

So let’s imagine some situations that can happen whilst working with an LP:

    1.  Your supplier informs you that due to the low volumes that you send him, he can’t hold your commission payments at this level and is forced to raise it.

2. The LP notifies you that some banks refuse to work with him because of the large number of small positions which you send him and as a result liquidity will be thinner and spreads correspondingly wider.

3. The LP stops pricing on an instrument from your list because of low volumes or other reasons.

4. You have a dispute with the LP after a technical failure on the provider’s side.

These are real issues faced by brokers on a daily basis. All these situations will put your business in an undesirable position. You will be forced to accept all these risks and as a result, carry the reputational and material costs. I should add that the process of connecting a new liquidity provider takes on average 2-3 months. It will not allow you to find an alternative solution quickly.

Thus, if you are using a model with one liquidity provider, you reduce the maintenance costs of your system but you may become completely dependent on the LP.

Conclusion

If the broker works as a market maker and needs an LP to hedge only part of a client’s positions, the business model of one LP is completely justified: if the LP changes the terms, or has a short-term technological issue, it will not threaten your business.

Conversely, brokers who provide their customers with access to interbank liquidity via an ECN/STP account cannot use only one LP. All the connection costs and maintenance fees of multiple providers in your system are a small price to pay for avoiding being bound hand and foot to a single LP, and having  to take all of its risk.